Higher risk makes investment-property financing more expensive
The high cost of residential investment properties:
- Interest rates are higher on investment properties to protect lenders from greater risk.
- Lender fees, title searches, appraisal reports and closing costs are more expensive on investment properties.
- Most lenders require at least a 20 percent down payment on investment properties.
- Investment borrowers should have enough cash reserves to cover expenses for several months.
When you go to purchase your first investment property, you will find that everything costs more than it did when you purchased the home you are living in. There is a simple reason for this: risk. Lenders believe people are less likely to default on their primary residence than on an investment property, for a variety of reasons, so they are more willing to take a chance on lending money on a primary home.
Investment properties are more expensive
To account for this extra risk, everything involved in purchasing a residential investment property gets more expensive. Mortgage interest rates could be anywhere from 25 to 75 basis points higher (one-quarter to three-quarters of a percentage point) — and these can increase even more with multi-unit investment properties, which require more tenants to recoup expenses. Closing costs, including points and fees on everything from title searches to appraisal reports, will cost more. Even property insurance will likely be more expensive, especially if the property will be vacant while you remodel.
Most importantly, you will need at least a 20 percent down payment to purchase an investment property, and this can rise to 25 or even 30 percent, depending on the property and your debt-to-income ratio — which is how much you owe, including mortgages and other loans, compared to your income sources. So, on a $100,000 investment home, you could be expected to come up with $30,000 of your own money to secure a loan.
These higher down payments protect the lender by making sure you have some "skin in the game," which means you will be less likely to walk away from the property if the economy falters — making it harder to rent or resell the property for a profit. Investment properties also are not eligible for mortgage insurance, which lenders typically use to insure against the risk of allowing a low down payment.
To further protect their investment in your investment property, lenders may require you to have a certain level of cash reserves in the bank — enough to cover several months of personal and property expenses — such as taxes, utilities and upkeep. These reserve amounts increase as you purchase more investment properties. Speaking of taxes, one drawback many first-time investors fail to realize is that the tax deduction homeowners can take on the interest paid on a mortgage is only for their primary residence — the one you live in. You cannot claim a deduction for interest paid on an investment property.
Down payment options
Although low-down payment loans that use mortgage insurance to help hedge against risk cannot be used for investment properties, there is a bit of a loophole in the case of some transactions. Loans backed by the Federal Housing Administration (FHA) or the U.S. Department of Veterans Affairs (VA) can be used to finance the purchase of multi-unit homes — up to four units — so long as the owner resides in at least one of the units.
That means, as long as you live there, you can purchase a duplex, triplex or quad-plex with a low-down payment FHA loan or VA loan with mortgage insurance, and then rent the remaining units out to tenants. You can even use an FHA 203(k) renovation loan in this way. You can purchase a triplex with a low-down payment 203(k) loan and secure extra funds to renovate the entire property as long as you plan to live in one of the units.